The Rebirth of the Actively Managed U.S. Stock Fund
By Nic Colas of ConvergEx Group,
The persistent negative investment flows at U.S. listed mutual funds specializing in domestic stocks is one of the most important long-term trends catalyzed by the Financial Crisis. AUM has dropped by $473 billion since January 2007 despite the S&P 500 Index’s essentially flat performance over this period. The news is no better since the beginning of 2012 – despite the ongoing rally in domestic equities – with $6.8 billion of further outflows year to date. In today’s note Nic Colas, of ConvergEx analyzes what will reverse this trend along two vectors: the desire and ability of individuals to invest. The rally in risk assets, along with declining actual volatility, is the best hope for a reversal in money flow trends. Offsetting that factor are continued stresses on household budgets and consumer psychology combined with problematic demographic trends. Bottom line: domestic money flows have likely become more economically sensitive than in previous cycles.
Like many investment professionals who came up through the ranks as single stock analysts, I turn to time-tested but industry-specific paradigms when analyzing unfamiliar business problems. In my case, that means pulling lessons from a decade-plus of staring at the U.S. auto industry for clues about how and when individuals choose to spend their money on large purchases like cars and trucks. These products are typically deeply cyclical in terms of demand. A good year might see 16 million or more units move off dealer lots. A bad year would register 12 million or less. Product pricing follows the same contour; a weak market means more incentives – a polite word for the old Lee Iacocca catch phrase, “Buy a car, get check!”
Back in the early 1990s, Chrysler’s chief economist – a talented and gregarious fellow named Don Hilty – walked me through his model for assessing how the American consumer decides it is time to buy a new car. This calculus was critical for Chrysler, since it had little in the way of overseas operations to buffer the shock of a weak U.S. market. Getting demand levels correct – and therefore production and dealer inventories - was worth well over $100 million in incremental profits, and Don’s assessment of the market was the lead presentation at every company Board of Directors meeting. Here’s how he broke down the challenge of calling the domestic auto market:
- Ability to spend. This factor centers on employment, wages, and household wealth. Don focused much more on directional changes than static levels. Rising employment meant more consumers could qualify for a car loan. A rising stock market and/or an improving residential housing picture meant buyers might feel a “Wealth effect” and purchase more of Chrysler’s cars and trucks. Wage growth was often the icing on the proverbial cake.
- Desire to spend. Don put just as much focus on how consumers felt about their economic picture as what the numbers said they should feel. Consumer confidence was just as important a factor in his model as the monthly employment data.
As I ponder the state of the U.S. mutual fund industry, with its difficult five-year track record for money flows out of domestic equity funds, several points of the Chrysler demand model seem to illuminate both current challenges and potential solutions. A few points to baseline and support this comparison:
- Money flows out of U.S. stock mutual funds is one of the most persistent trends in global capital markets since the beginning of the Financial Crisis. From January 2007 to January 2012, some $473 billion has come out of domestic equity funds. According to data from the Investment Company Institute, there have only been 15 months of positive money flows in these last 61 months.
- Aside from two large outlier months in 2008 – ($45) billion in October 2008 and ($36) billion in January 2008 – some of the heaviest outflows came in 2011. The period from June to August last year saw an average of ($25) billion pulled from domestic equity funds every month.
- What is most striking about this trend is that it breaks with long-held beliefs about how investors behave during bull and bear markets. The annual ICI factbook (see here: http://www.ici.org/pdf/2011_factbook.pdf) has a chart that shows in/outflows back to 1996 for equity products, and the correlation between performance and capital is undeniable. Upward trending markets see inflows. Until now, anyway, when a three year bull market is not enough to entice investors back into U.S. stock funds.
Now, pulling in the Chrysler demand model, let’s see how Don Hilty’s deconstruction of U.S. consumer behavior fits with the seeming anomaly of positive performance and negative money flows. There is one leap of faith here, but I think it is more of a hop than a running-start jump across the abyss. We have to think of investing as a consumer good, rather than a purely rational expected return calculation. That may be unconventional from a pure finance perspective, but the facts seem to fit pretty comfortably inside this paradigm.
- Ability to spend/invest. Despite the recent upturn in U.S. economic data, there is no doubt that the domestic economy is puttering along more than it is accelerating rapidly. Job growth is modestly better, but unemployment is still twice any reasonable estimate of structural (i.e. “Normal”) joblessness. Wage growth, as measured by Federal tax and withholding receipts, is only higher by 2-3%. At the same time, headline inflation is picking up, thanks primarily to higher oil prices. Stock returns over the past three years are, of course, profoundly positive. Still, the longer-term record is stagnant. And the volatility of the last half-decade means that only the bravest investors had a chance of recouping their losses. Therefore, any wealth effect is likely muted by investors bailing out at or near a bottom (recall those record negative flow months in 2008) as well as fears that similar volatility may return in the near future.
- Desire to spend/invest. U.S. stock funds face two central challenges as they try to turn the money flow picture more positive. On one count – perceived market volatility – the trend is currently their friend. The CBOE volatility index has come down to 15, well below its 21 year average of 20, indicating that options markets see below-average near term risk. Actually volatility is even lower over the past month. Balancing this positive are two concerns – one immediate and one longer-term. In the here-and-now, consumer confidence is still quite low, with the most recent University of Michigan survey registering a surprising drop to the lowest levels of the year. If you agree that retail investors need to be confident in their own economic future before they will put money back in the stock market, this is a cautionary signal. Over the longer term, many market observers worry that investor demographics may also become an incremental headwind. The logic here is that as individuals age, they become less willing to take the risks of owning equities and prefer more stable fixed income investments.
Using the Chrysler vehicle sales paradigm leads me to the conclusion that money flows into U.S. mutual funds face somewhat of an uphill battle, but are probably more levered to the overall state of the U.S. economy than in prior investment cycles. Investors need the same economic tailwinds as car buyers – incremental cash flow and the confidence to spend it. If we are at the opening stages of a more durable economic recovery in the U.S., then the inflows should follow. In fact, money flows may end up being a decent indicator of when/if the current uptick in the economic data is actually self-sustaining.
On a closing note, I think there is another area where the automotive/investment comparison intersects: exciting product. Chrysler in the 1990s was the hottest domestic auto company because it had a market-leading minivan and was consistently two steps ahead in developing best-selling sport-utility vehicles and newly competitive pickup trucks. Yes, they had a cyclical recovery at their backs. But they made the most of it with fresh product that generated showroom traffic and incremental sales.
The mutual fund industry should take note of that lesson. Money flows will turn positive at some point with an improving economy. The golden age of the domestic mutual fund had rock star managers – Peter Lynch, John Neff, John Templeton, Mario Gabelli, and scores of others. I can’t help but think that the next wave of mutual fund inflows will really come roaring back when a new crop of rock stars makes themselves known. The Exchange Traded Fund industry has a lock on the low cost, index-based, highly transparent, tradable investment product. Actively managed equity funds need to continue to differentiate their products, and the managers involved represent the best vehicle to deliver that message.